The RBI, as expected, kept the policy repo rate unchanged at 6%. The tone of the policy is neutral to hawkish, effectively signaling that the RBI could pause for some time before its next move. However, the focus should now shift to how the RBI would look at the inflation trajectory in FY2019 and how its reaction functions would pan out. We maintain our call that the rate cut cycle is broadly over, for now. It is too early to talk about whether and when the RBI will hike rates, but there is a case for caution as we step into the new year.

Even as debates continue as to how much room the RBI has to cut rates, the central bank itself remains cautious on the inflation trajectory. To justify the concerns on inflationary pressures, it has outlined various factors such as upward risks to core inflation, rising input costs, staggered impact of state governments' HRA implementation, global crude price dynamics, and fiscal policies of union and state governments. It is important to note that the RBI is positive on the growth prospects for FY2019 on the back of recent reforms implemented by the government. This would be instrumental in their outlook for the output gap and consequential inflationary pressures, going forward.

For FY2019, we pencil in inflation staying above the RBI's comfort level of 4% and closer to the 5% mark. In fact, we see the inflation trajectory peaking in June 2018 at around 5.5-6.0%. For the rest of FY2019 it is likely to range between 4.5-5.0%. Households' inflation expectations can quickly feed off a sustained high inflation phase which can be dangerously self-fulfilling. The RBI's credibility in anchoring generalized inflation hinges on its ability to keep a lid on inflation expectations.

Further, we factor in a modest cyclical recovery in GVA growth in FY2019 to 7.1% (from 6.5% in FY2018) which will be predicated on government expenditure in a busy political calendar and run up to the general elections along with normalization of demonetization and GST-led disruptions. Without an immediate increase in the potential GDP of the economy, this can lead to a narrowing of the negative output gap (difference between the actual and potential growth rate). Increasingly as the output gap narrows, inflationary pressures could increase.

To this growth-inflation mix, one should also add the (1) uncertainty on fiscal space on the back of GST collections and quality of general government expenditure, and (2) risks from global factors such as commodity prices and monetary policy cycles.

Overall, the macro fundamentals are entering a more challenging phase which warrants a certain degree of cautiousness. The conditions, as of now, remain fluid with several variables at play through the course of the next year. As a central bank, the RBI will prefer to err on the side of caution. Staying put seems the best action for now but one should keep an eye out to spot a shift towards any rate hikes.